Japan is back on a knife edge between a market plunge or market recovery as the banks work through d...
Japan is back on a knife edge between a market plunge or market recovery as the banks work through debt forgiveness/write off. This is a story in three parts: first, why the market is so bearish; second, the grounds for optimism; and finally, the call on the banks, always the hardest call of all in Japan.
Japan has suffered a long drawn-out bear market with a brief euphoric rise in 1999 underpinned by the belief that restructuring was at last being undertaken in earnest. The euphoria was overdone: the market peaked in February 2000 as profit takers moved in. This was exacerbated by the collapse of Nasdaq, which sent Japanese technology stocks into sharp decline.
The mood on the Japanese market is bearish. There is a lengthy catalogue of negative issues for the bears to focus on, the key issues being a slowing economy, declining corporate profits, significant overhang of shares and the risk of deterioration in the US economy.
Economic data shows the economy is slowing. Most forecasters expect around 1% growth in GDP for fiscal year 2001, having cut forecasts progressively as more negative news emerges. The main concern is export growth, reflecting the slowdown in the United States and Asia. Private consumption growth has remained weak and rising inventory to shipment ratios point to a slowdown in production growth this year.
Analysts' forecasts for fiscal year 2001 in real terms are falling and companies are likely to start to revise down fiscal year 2001 numbers. Furthermore, extraordinary losses are likely to be announced before the end of March.
The excess supply of overhanging stock is depressing the market. The estimated ¥2trn of unwinding cross-held shares in the first quarter is unhelpful. This is reinforced by further substantial supply expected from the IPO market. In addition, Japanese institutional investors have heavy weightings in Japanese equities. These are likely to be reduced as investors seem to be moving increasingly to a more cautious stance regarding the prospects for the Japanese market. Investment trusts are seeing outflows for the first time since 1998, which is doubtless due to the pain felt following the recent share price slide.
While we believe the US economy will achieve a soft landing, there is an increasing risk of it being hard given the weakening of the perceived wealth effect that has underpinned consumer spending and the growing reluctance of banks to lend to companies. Despite the litany of doom and gloom, there are reasonable grounds for optimism for the medium to long term. Putting aside the systemic risk in the banking sector, which, in our view, is the third section of the main story, most of the bad news already seems to be in the price. It would seem that there is comparatively limited downside in the market from current levels.
Japanese companies are continuing to restructure. We have seen some evidence of better corporate governance, industry consolidation is progressing and there is a greater willingness to spin off/sell/close down businesses that do not fit with the core company.
Japan has also, at last, started to evaluate proposed capital expenditure projects against return on investment criteria and belatedly introduced consolidated accounting. Consumer spending looks likely to improve gradually as the employment and income situation slowly improves.
Japanese stocks are looking much less overvalued as a result of the recent fall in the share prices. Against traditional valuation yardsticks, one might argue that the shares look inexpensive. However, given the expectation that the earnings are still too high, we would treat valuations with caution.
The turning point for the market is likely to be whether or not the Government can deliver on new policy initiatives and whether the Bank of Japan acts decisively. The central issue is the banks' non-performing loans. If these are disposed of satisfactorily it is likely the market will move from an ultra bearish stance to just bearish. This could translate into a 10-15% rally in the Nikkei. Such a rally would be focused not in the former darlings, namely the technology stocks, but the perceived poor-quality stocks such as banks and domestic cyclicals, the Old Japan stocks.
Thinking was that the 1999 Financial Revitalisation Law, which re-capitalised the banks and put a safety net in place for dealing with failed institutions, had resolved the non-performing loan issue and averted the systemic risk of the banks imploding. The focus had been on recovering from the banks the money lent to them.
Given the extreme pessimism regarding the Japanese market, the fact that the key fiscal year-end of 31 March is fast approaching and the Government's lack of popularity in the run up to the July elections, focus is now shifting to prioritising debt forgiveness/write off.
The Catch 22 syndrome arises because it is difficult for the economy to recover while there is an overhang of an estimated ¥40trn of cumulative loan losses for the major banks. Loan forgiveness and debt workout will increase the already deflationary pressures in the short term, causing asset values to fall further and thereby erode collateral, thus triggering more non-performing loans. Banks will have insufficient profits to forgive the bad debts unless the economy grows.
The way to break the negative circle is to remove the requirement under the Financial Revitalisation Law to repay the Government or be nationalised. The problem, of course, is that this would be a major policy U-turn ahead of the election, but probably a necessary one. The Government might be able to sell it to their supporters as the debt workout would help their constituents, namely severely impaired construction and real estate companies.
The failure to pursue debt forgiveness hitherto has been the reluctance to bail out the banks with public funds without exacting an appropriate quid pro quo, together with concern that the disposal of the underlying loans would harm the economy.
The solution that now seems to be emerging is that the Government, Bank of Japan and corporates work together. If the Government forces through debt forgiveness and asset disposal and eases monetary policy, we can expect a rally. Whether after this Japan sinks back into doom and gloom will depend on if the US sees a stronger second half. If it does, this would be upbeat for global economies and could sustain Japan's rally.
The expected rally could be a little joke by the Japanese on the foreigners designed to get the market up for the fiscal year end. Japan is a consensus driven culture. The process of change seems, by Western standards, interminably long but Japan watchers are wary that once agreement is reached, change can be very fast. Therein lies the excitement of investing in Japan.
Sheila Martin is director of Japanese equities at Clerical Medical
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